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The German Federal Constitutional Court Decision on the German Transfer Tax System and its Impact on German Estate Planning

On December 17 2014 the German Federal Constitutional Court decided on the German inheritance tax system especially on its special business assets exemptions in the German Inheritance and Gift Tax Act. Currently, the German transfer tax system grants an 85 % or even 100 % discount on the transfer of proprietorships, interests in commercial partnerships and shares in corporation in case the testator or donor owns a minimum stake of more than 25 % in the respective corporation. These tax exemptions are connected with very complicated claw-back-clauses. These tax exemptions are very technically designed and allow aggressive tax planning schemes including the transfer of so called "administrative assets". These tax exemptions did not distinguish between small and large enterprises. Due to these generous tax exemptions it was possible in the last years to transfer business operations independent of its size with an almost zero tax burden to the next generation. Never in history post World War II was the German inheritance and gift tax system so generous.

The court decided that the existing legislation is unconstitutional. The legislator has to introduce new regulations until June 30 2016. The court declared that the current provisions will continue to apply until then. In addition it is prohibited, at least in principle, the retroactive application of the new legislation to the date of the decision. Nevertheless, the legislator is entitled to introduce retroactive regulations designed to prevent so called "excessive exploita-tion schemes" of the business assets exemptions, but it is not required to do so.

Basically for two reasons the court qualified the business asset exemptions as unconstitutional. One reason is that due to the technical design, it was quite easy to develop schemes which allowed the transfer of assets in a business or corporate "wrapper" although the underlying asset was an asset which can be also used for private purposes. But more importantly the court held the tax exemptions were unconstitutional because they were applicable without any needs test.

Currently, the German States and the Federal Government are liaising about how the new laws should be designed. On June 2 2016 a first draft was published by the German Federal Finance Ministry.

The proposal for the new rules are very harsh compared to the old rules. The suggestion of the German Federal Finance Ministry basically is that the current 85 % or 100 % discount can only be granted for transfers of business assets not exceeding the value of EUR 20 mil. or in certain situations of EUR 40 mil. If the value of 20 mil is exceeded, but the value of 110 mil not reached, then the 85 % discount is minimized by one percent for every EUR 1.5 mil in which the transferred assets exceed the amount of EUR 20 mil. Above 110 mil., a 25 % or

40 % discount is applicable.

In such a situation, the donee or heir can also enter in a so called needs test in which he has to prove that he cannot pay the triggered tax with 50 % of his other assets or he can accept a general 25 %/40 % discount on the inherited business assets if he cannot pass the needs test.

This proposal does not meet the approval of the States so difficult political negotiations will take place during the course of the next few months. It is also expected that the whole transition period will be needed until June 30 2016.

Therefore, there is a need for action for entrepreneurs who own a strong and valuable equity position which exceeds the thresholds for small and medium sized enterprises. As retroactive legislation is not to be expected, the next months should be used for considering how to use the current very generous business assets allowance in the German transfer tax system.

Foreign investors are affected by the upcoming new legislation if they choose to invest via partnerships structures into German business partnerships. They are not affected if they invest into German companies or partnerships via foreign holding corporations because in a situation of German limited tax liability for domestic assets a foreign holding corporation owning German assets does not qualify as domestic property according to the German Inheritance and Gift Tax Code.